Yuan Forex Rate Needs Adjustment
By Tung Chen-yuan 童振源
Taipei Times, June 17, 2004, p. 8
In recent months the Chinese government has tried administrative measures to rein in
its overheated economy. These measures have included proposals that the central
bank should strengthen credit management, restrict land development, increase the
self-financing ratio for companies in overheated industries, attempt to terminate
unreasonable investment projects, request that local governments control commodity
prices and implement restrictions to slow expansion of the money supply and credit.
But why doesn't China want to cool its overheated economy through traditional
monetary policies, such as by raising interest rates or revaluing its currency?
China does not want to raise interest rates for four reasons. First, the Chinese
government worries that a sudden big cut in expenditures or an across-the-board
increase in interest rates will affect the economic growth rate, leading to high
unemployment and social instability. Late last year, registered urban unemployment
reached 4.3 percent. According to official Chinese statistics, 29 million urban workers
will need jobs this year. High economic growth is required to supply the job
opportunities needed to meet the demands of such huge numbers of employment
seekers.
Second, industrial investment in China is seriously imbalanced -- some industries are
overheated, yet for about 80 percent of products, supply exceeds demand. Raised
interest rates will affect investment in every industry, which will bring serious
deflation to some industries.
Third, although fixed industrial investment in China grew by 43.5 percent in the first
quarter, investment in agriculture, forestry, fisheries and livestock only increased by
0.4 percent, and even experienced negative growth in the first two months of this year.
Increased interest rates will make it more difficult for agricultural industries to obtain
loans, and this will aggravate problems for the agricultural sector, villages and
farmers.
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China's current macroeconomic controls aim to both cool down and heat up different
parts of the economy. This is far more difficult than simply cooling down the
economy as a whole.
Fourth, if the US government does not raise interest rates, the Chinese government
may not be able to solve its problems by raising interest rates to slow credit expansion.
The interest rate for one-year yuan deposits is 1.98 percent, while the interest rate for
one-year US dollar deposits is 0.5625 percent, a difference of 1.4 percentage points.
An increase in Chinese interest rates will attract more hot money in search of
arbitrage profits, and that would increase the domestic money supply.
Following China's adoption of several policies to cool down the economy in April, the
fixed-asset investment growth rate for that month fell from 43.5 percent to 34.7
percent, industrial added value fell slightly from 19.4 percent in March to 19.1 percent
in April, and new projects in April only increased by 5.9 percent year-on-year. These
figures are evidence of the efficacy of the cooling-down policies.
Although the problems of overheating and imbalance in the Chinese economy already
have been somewhat alleviated, the overall trend remains unchanged. The increase in
the consumer price index (CPI) grew from 3 percent in March to 3.8 percent in April,
while growth of the broad money supply, M2, remained at 19.1 percent both in the
first quarter and at the end of April.
Last last month, Bank of China president Zhou Xiaochuan (周小川) and Li Yang (李
揚), a Monetary Policy Committee member, hinted that the Bank of China may raise
interest rates if the CPI increases by 5 percent. It is not at all certain, however, that
raising interest rates will solve the problem. It might even aggravate matters,
including such things as increasing the imbalance in investments and leading to a
continued increase in the money supply.
For the time being, the yuan exchange rate remains the key issue. Merrill Lynch
estimates that the yuan is undervalued by about 20 percent, that maintaining an
essentially fixed exchange rate will lead to inflation growth in China by 2 percent to 3
percent annually, and that the aftereffects of the recent credit expansion may add
another 1 percent to 2 percent to the inflation rate. That means that before the end of
the year, China's inflation rate may reach as high as between 6.5 percent and 9.5
percent, or even into the double digits. That would force the Chinese government to
face head-on the problems posed by an undervalued currency.
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Given the nominally fixed exchange rate, the Chinese government estimates that the
3.8 percent CPI increase, lowered import taxes and export tax refunds have caused the
actual yuan exchange rate to increase by between 5 percent and 8 percent. During the
first four months of this year, however, the amount of unexplained foreign exchange
increased by 72.4 percent year-on-year, implying that China probably will not attract
less international hot money this year than it did last year. This will put heavy
pressure on the money supply.
Clearly, foreign exchange markets have not understood China's assessment of the
situation, but remain filled with expectations of a revaluation of the yuan. It therefore
seems that if China wants to cool down the overheated economy and correct its
imbalances, an appropriate adjustment of the exchange rate level and system is
unavoidable.
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